Even rallying markets provide opportunities for enhancing your after-tax returns

With the U.S. equity market broadly rallying so far this year, investors may be hesitant to invest into loss harvesting strategies given the common perception that loss harvesting only works in down markets.

While tax-loss harvesting works best in downwards-trending and volatile markets, the strategy can provide value in upwards markets as well given the natural bumps along the way – for example in April of 2024 when the markets dipped by about 5%. Tax-loss harvesting strategies are designed to give you tax-smart equity exposure—and potentially lower your ultimate tax bill—by capturing (or “harvesting”) losses that you can use to help offset capital gains. Always practical for enhancing tax efficiency in your equity portfolio, the strategies become particularly attractive in uneven markets, when directional trends can be unclear. 

Even upwards markets can have loss harvesting opportunities

While uncertainty around interest rates and sticky inflation have captured investors’ attention, the stock market has rallied so far through May – with the S&P 500 up by 6%. That said, bull markets aren’t immune to pullbacks, as we saw with the 5% pullback in April.  Even in the best years, that’s to be expected. The 10 best calendar years since 1980 saw an average total return of ~30%; all but one of those years had at least one 5% pullback.

These market dips create ideal conditions for implementing a loss harvesting tax strategy¹, because market volatility—whether in bullish or bearish markets—tends to create clear winners and losers.

For tax-savvy investors, that dispersion matters: Tax-loss harvesting tends to work best in choppy, hard-to-navigate markets. In 2022, for example, as equity markets plunged into bear market territory and volatility spiked, investors could have benefited from potential tax savings. In 2023 – when the market returned 26% for the year – dispersion of returns for index constituents also created opportunities for capturing losses.

Capturing “tax alpha” in your equity portfolio

How, exactly, does tax-loss harvesting work?

At its simplest, tax-loss harvesting can help you reduce your tax burden. It allows you to recognize losses that can then be used to offset capital gains in other parts of your portfolio. The key is that the loss must be realized; it cannot be on paper alone. Painful as it may be, realizing losses can have a meaningful, positive impact on your ability to achieve your overall wealth goals.

You can still preserve your asset allocation by buying a similar stock to take advantage of any potential long-term upside. In this way, you can capture losses and use the tax relief to your benefit while keeping your portfolio aligned to your overall investment objectives.

Be careful, however, not to breach the “wash sale” rule² when choosing the replacement stock.

Over time, the compounded value of potential tax savings relative to a simple, passive investment in an equity benchmark (e.g. an exchange-traded fund (ETF) or an index tracker fund) can be significant. For example, if you owned a $10 million equity portfolio, being able to realize a tax benefit of 1.5% in a single year would result in potential tax savings of approximately $150,000, which could be used that year (in which the loss was realized) or carried forward, to offset gains in future years and reduce your overall tax burden. This approach becomes even more valuable when you’re able to stay invested over decades and allow your tax savings to compound.³

For those investors who are willing to get—and stay—invested, the potential to realize this kind of tax alpha may actually increase in years when markets turn volatile. In fact, the greater the differential between rising and falling stocks, the bigger the potential tax savings. Loss harvesting can be seen as the silver lining of falling markets, and a potential added benefit for upwards-trending markets. 

Tax-loss harvesting can be an effective strategy in both up and down markets for generating potential tax savings. Although bull markets may not present as many options for loss harvesting as bear markets, they can still produce meaningful opportunities for capturing tax losses. Ultimately, directionality is less important a driver than the natural, ongoing volatility of equity markets—and the dispersion of returns that they produce.

Between 2017–2023, for example, the S&P 500 returned an average of 13.4%, but the market also experienced a fair amount of dispersion among individual stock returns. In each of those years, around 170 stocks on average posted negative annual returns, creating opportunities for tax-loss harvesting.

Innovative technology enables robust tax-smart investing

Thanks to the power of technology, harvesting of losses (and their replacement with comparable stocks) can now be done on a systematic, ongoing basis. Whereas in prior years, investors may have only looked at opportunities to harvest losses at year-end, robust technology now enables us to monitor accounts daily to capture losses throughout the year to enhance the effectiveness of tax-loss harvesting.

We can help

If you would like to know more about rebuilding your equity exposure in a tax-efficient manner talk to your J.P. Morgan team. We are here to help.

¹ Tax-loss harvesting may not be appropriate for everyone. If you do not expect to realize net capital gains this year, have net capital loss carry-forwards (i.e., tax losses not used in the year in which they are realized), are concerned about deviation from your model investment portfolio, and/or are subject to low income tax rates or invest through a tax-deferred account, this strategy may not be optimal for your account. You should discuss these matters with your investment and tax advisors.

² The wash sale rule states, in essence, that a loss will be disallowed if taxpayer sells a security at a loss and acquires the same or a substantially identical security (or an option on such security) within 30 days on either side of the date the loss was realized. The disallowed loss is then added to the cost basis of the substantially identical acquired security and generally recognized when the position is later sold.

³ Past performance is not indicative of future results. It is not possible to invest directly in an index.